Interest Only vs Principal

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Paying the Principal On an Interest-Only Loan

Question: I just bought my first house, and I have an "interest only" mortgage. That is, for five years I've got a rate locked in and I only have to pay the interest on the loan. Hence, my mortgage payment is about $1,900 a month. Five years from now, the rate adjusts up and I will have paid down zero principal on the $475,000 loan.

Is it worth it to pay, say, $2,000 or $2,100 or even $2,500 (if it's a good month) whenever I can to chip away, however incrementally, at my principal over the next five years? Or am I better off saving any extra cash and investing it, at a time when money markets are paying less than 1% and the stock market is so volatile?

-- Steve, location not provided

Steve: You may well be better off investing your money rather than paying down principal, but much will depend on your tolerance for risk.

Most Americans assume it's always best to pay down their mortgages as quickly as they can. But in a lot of cases that's not always true; indeed, that's the whole idea behind an interest-only loan.

For the uninitiated, interest-only mortgages work like this: First, the borrower takes out a 30-year mortgage, electing to pay only interest for a set period of time, such as five, 10 or 15 years. After that, the monthly payments readjust to include the principal, amortized over the remaining years of the loan. This can cause the monthly payments to rise substantially.

The advantage of an interest-only loan is that it allows a borrower to free up capital to invest in assets that yield the highest return, or serve some particular financial-planning purpose, rather than locking it up in a house. For example, you could take the money you'd be paying in principal each month and invest it in the stock market. Or, you could set it aside to help pay for a child's college fund.

Say you have $100 in extra funds one month and you're trying to decide whether to invest it or pay down principal on your house. If you devote the money to paying principal, you'll wind up reducing your interest-only mortgage payments by $4 over a year's time, according to a scenario constructed by Bankrate.com, the personal-finance website. But you won't be able to deduct as much interest as before from your taxes. If you're in the 28% tax bracket, you'd wind up with a tax deduction that's $1.12 smaller than before. So your net savings would be $2.88 over the year, which equals a 2.88% annual rate of return after taxes, by Bankrate's calculations.

That's a far cry from the 8.5% average annual after-tax return that investors generally expect from the stock market over the long haul. Of course, that's where your tolerance for risk comes in. Everyone knows the stock market has been volatile lately, and if your idea of stock investing is to load up on shares of some hot new tech stock, you might want to just pay off your mortgage. But if you're willing to park your money in a diversified mix of stocks long enough to ride out any cyclical ups and downs, you should be in good shape. You certainly wouldn't want to put the money in a money-market fund. Given current market conditions, you'd be lucky to eke out a 1% annual rate of return from those investments.

There are other scenarios in which it makes sense to skip paying principal. For example, if you have huge amounts of credit-card or other high-interest debt, it might be best to take the money you have earmarked to pay down principal and use it to pay down your other, more expensive debt. Or, say your employer has a program to match your contributions to a 401(k) plan. If you're not taking full advantage of that program, you might want to use the money you had set aside for principal payments to boost your monthly 401(k) contribution.

In those and some other scenarios, "you won't have paid down your mortgage at all, but your financial picture outside your mortgage will be much more robust," says Bob Walters, the chief economist at Quicken Loans, an online lender based in Livonia, Mich. He says about 15% to 20% of his company's clients are taking out interest-only loans these days, and the percentage is rising as home prices and interest rates climb.

To be sure, there are plenty of pitfalls in not paying down your principal. For one thing, you'll be building up less equity in your home. That shouldn't be a big problem, since you will be accumulating equity as the property appreciates in value. But if you think you live in a market where prices aren't likely to rise much, or might fall, you might want to pay down some of the principal to give yourself an extra cushion of equity.

You also need to know yourself: Are you the kind of person who will have the discipline to invest wisely or pay down other debt if you don't pay down your principal? "If you take the money and go out to Vegas, that's a bad idea," says Mr. Walters at Quicken Loans. You also need to be careful not to use an interest-only loan to get yourself overextended. Some borrowers take out interest-only loans so that they can afford much bigger houses than they'd be able to buy otherwise, only to get whacked later when the loan readjusts once the interest-only period is over.
The basic point is that you need to think hard about your long-term financial goals and your investment strategies before deciding what to do. If you're more comfortable taking the more conservative route and paying down your mortgage early, by all means do it. You'll sleep more easily at night. But if you know what you're doing when it comes to smart investing, your money can go farther if it's invested somewhere else rather than tied up in your mortgage.


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